The Capital Investment - Case Study Example

Mineral Plc Report on the Capital Investment Proposal November 30, 2009 Mineral Plc Report on the Capital Investment Proposal Introduction This report is an analytical summary of the proposed capital investment proposal of Mineral Plc (hereinafter referred to as the 'Company' in this report) for undertaking mining projects in Medco Republic (MR). The Company is in the process of restructuring its operations and is contemplating to improve the profitability by diversifying in to different business areas. The Company is exploring the possibilities of expanding its operations in to the African country of Medco Republic. This country has until quite recently been inflicted by conflicts and regarded politically unstable. This report becomes necessary in view of the earlier political instability prevailed in the country. Even though after the democratic elections conducted in the year 2005, the country has been advised to be a safer destination for capital investments, there have been apprehensions about the stability of the country and the chances of the conflicts arising again which may hinder the sustained growth of the company's operations in the country. Apart from the political risk, there is the issue of Company's Social Responsibility and the related costs and ethical values that need consideration before taking any decision on investing in Medco Republic. In addition the report focuses on the foreign exchange risk in dealing with the currency of Medco Republic. The objective of this report therefore is to consider the soundness of the proposed capital investment from the angles of financial feasibility, country risk of Medco Republic and the foreign exchange risk in undertaking transactions in the currency of Medco Republic as against the British Pounds as the investments the commitment of substantially larger sums by the Company to be recouped over a longer period. The analysis is based on a review of the net cash flows from the project using the recognized capital budgeting evaluation methods of Net Present Value (NPV) and Internal Rate of Return (IRR), taking the weighted average cost of capital of the Company of 15% as the hurdle rate and the rate for discounting the present value of future cash flows from the project. Financial Feasibility The financial feasibility of any capital investment proposal can be judged based on the ability of the project to enhance the shareholders' wealth by contributing positive net cash inflows from the proposed investments. Just any other domestic capital project is being evaluated, for the international investments can also be evaluated by calculating the 'Net Present Value' (NPV) future cash flows expected out of the project. The NPV of the project depends on the initial investment or initial cash flow, expected future cash flows and the cost of capital. Based on the comparison of the NPV of the future cash flows with the proposed capital investment the feasibility of the project can be established. While working out the NPV the effect of the factors like Sales creation (additional sales), cannibalization (loss of sales), opportunity cost, transfer pricing and fees and royalties on the future cash flows should be taken into account. The Internal Rate of Return (IRR) is the other criterion that needs to be carefully looked into while deciding on the capital investment. In the case of the proposed capital investment proposals the NPV and IRR from the projects have been worked out and exhibited in the Appendix. From the NPV calculations it is observed that the project has a negative net present value which implies that the project is not acceptable. The internal rate of return (IRR) is also much lower than that of the weighted cost of capital of the company. As against the cost of capital of 15% the IRR from the project works out to 5%. This also indicates that the proposed investment is unviable. Even though the Company can set off the tax payments in the country of Medco Republic against its income tax liabilities in the UK because of the existence of double taxation treaties, for the purpose of calculating the net cash inflows from the projects, the taxation in Medco Republic has been taken into account. The project is not worth considering even if taxation is removed from the calculation as the present value is much on the negative side. Country Risk The country risk can be assessed based on various factors including political and economic structure risks. Haner & Ewing, (1985) defines country risk as "the prevention of losses from sociopolitical, financial and operating risks, all of which are necessary and sufficient conditions for measuring the risk incurred on the business by operating in a foreign country". Country risk is an important factor in deciding the expected return on investment and has to be considered in full while any company wants to invest in a foreign country (Investopedia, 2009). The analysis of country risk normally covers the potential of the country in respect of its natural and human resources, and the willingness and ability of the government to recognize economic and budgetary problems. The government should also be in a position to take appropriate remedial actions wherever necessary. The country risk is enhanced by trends towards the government-imposed price, interest rates and exchange control measures. The desire of the country to support the international business needs of domestic customers also determines the degree of country risk against the business environment. A number of weaknesses such as environmental issues affecting sustainable economic growth, growing social tensions caused by rising economic inequality and the internal conflicts between different factions, and under-capacity in industrialization because of poor infrastructural facilities affecting growth in various sectors, have substantial influence on the sustenance of the economic growth of Medco Republic. This is likely to have a major impact on the future sustenance of the Company's growth and operations in Medco Republic. Foreign Exchange Risk Foreign exchange transactions are susceptible to foreign exchange fluctuations in that there will be always be the possibility of the firm that deals with the foreign countries is subjected to such risks due to the nature of their transactions which involve large capital investments and returns from the projects to be repatriated. Especially for the company which wants to invest large capital in mining in Medco Republic being a foreign country, the exposure to foreign exchange risks is much more even at the time of investments as it has to transfer a large amount of capital to the foreign country for investing there. This risk continues when it continues to do the business transaction as the company would be transferring machinery and materials from and to the foreign location. Similarly there will be movement of funds from and to Medco Republic to the Company. These funds represent the sale value or profits transferred to Mineral Plc. "Some countries' currencies are more volatile than others because of their inflationary or unstable economies. This makes their exchange rates more liable to extreme movements." (Business Link) or even the value of investments and service being provided by the company in the UK to the entity in the foreign nation of Medco Republic. The exchange risks to which the company is exposed takes different forms depending up on the nature of transactions. They are: Transaction Exposure The transaction exposure is the result of the foreign exchange risks a firm is facing because of its contractual transactions with the entity in Medco Republic. The transaction exposure represents the fixed obligations of the firm against amounts receivable or payable under trading transactions. Transaction exposure risks are short term in nature. Such risks take place from the time the transaction is entered till the time it is concluded. Thus the transaction exposure is the result of foreign exchange obligations already contracted by the firms towards the payment or receipt in the foreign currency. Such exposures to fluctuating exchange rates often may result in huge losses to the business firms if they have not adequately covered themselves against such risks. The high risk on account of transaction exposure can be mitigated by undertaking a hedging strategy which protects the company from exposure to the transaction risks. Forward contracts, price adjustment clauses, currency options and borrowing in foreign currencies are some of the ways in which the Company can protect its financial exposure. Translation Exposure Financial Directory defines the 'Translation Exposure' as the "Risk of adverse effects on a firm's financial statements that may arise from changes in Exchange rates." Because of the investments in Medco Republic the company is sure to acquire assets and incur various liabilities in that country. Moreover the country will derive income from the operations of that country also. When the company wants to value these assets acquired and liabilities contracted in the foreign country, naturally an exchange rate needs to be adopted for the valuation. Because of the change in the value being adopted for the foreign currency the value of assets and liabilities may get vitiated resulting in a loss to the company. As this risk purely is the outcome of the accounting treatment to the assets and liabilities of the company, the risk may also be termed as 'Accounting Risk'. The Translation exposure can be managed by adopting the techniques like adjusting the fund flows, entering into forward contracts and exposure netting. Economic Exposure Economic Exposure indicates the extent to which the firm's market value is sensitive to the unexpected changes in the foreign currency. Long term currency fluctuations affect the value of the firm's income statement, balance sheet by altering its competitive position in the country. Economic exposure depends on the unique characteristic of an industry and the individual characteristics of an individual firm. Economic exposure alter the position of the firms standing by affecting its sales value, cost of goods sold, operating profits, market share, share prices and the market value of the firm as such. Economic exposure arises when it is expected that future cash flows will be affected by a change in the exchange rates. Economic exposure is thus the extent to which the present value of the future cash flows are affected by the movements in the foreign exchange rates. Social Responsibility of Business Apart from the financial, political and foreign exchange considerations, there is the Corporate Social Responsibility of business (CSR) which also needs consideration both from the cost and ethical perspectives. With a negative net present value of the net cash inflows the Company cannot incur additional expenses for meeting the social responsibilities. At the same time, the Company cannot ignore its social responsibilities, as it is unethical on its part to just consider the addition to the shareholder value without caring about the environmental impact of the capital investment proposals. Ignoring the social responsibility will also affect the reputation of the company in the long run. Conclusion This report is aimed to comment on the feasibility of the capital investment proposal by Mineral Plc in the African nation of Medco Republic. The findings of this report are crucial in the wake of the political instability of the Republic as well as on the financial feasibility of the project. The foreign exchange risks in the proposed investments are also an important issue that needs consideration. Based on the calculation of Net Present Value (NPV) and Internal Return of Return (IRR) the project was found to be unacceptable. The country risk in the form of political instability does not support a sustained growth of the business of Mineral Plc in Medco Republic. There are transaction risk, translation risks and economy risks in respect of the foreign exchange dealings with the country which are potential risks the organization should consider before deciding to go with the investment proposal. The report also considered the financial and ethical issues connected with meeting the social responsibility obligations by the company. On an overall analysis the project cannot be considered as a viable one and the Company should find alternative investment options for diversifying and expanding its operations and should not commit large sums in the proposed investments in Medco Republic. References Haner, F.T. & Ewing, J., 1985. Country Risk Assessment Theory and Worldwide Practice. New York: Praeger. Investopedia, 2009. Country Risk. [Online] Available at: (http://www.investopedia.com/terms/c/countryrisk.asp) Appendix Mineral Plc Statement of Cash Inflows and Calculation of Net Present Value and Internal Rate of Return 2009 2010 2011 2012 2013 2014 2015 production/sales volume kg 10,000,000 11,000,000 12,000,000 13,000,000 10,500,000 price / 1000 kg 1,500 1,575 1,654 1,736 1,823 sales value - 15,000,000 17,325,000 19,845,000 22,573,688 19,144,223 Cost: chemical reagent cost @ 200/1000kg 2,000,000 2,244,000 2,496,960 2,759,141 2,273,090 Furnace cost 500,000 500,000 500,000 500,000 500,000 Labour wages 1,000,000 1,100,000 1,210,000 1,331,000 1,464,100 Land Clearing Charges 250,000 257,500 265,225 273,182 281,377 Depreciation 10,000,000 7,500,000 5,625,000 4,218,750 3,164,063 Total Cost 13,750,000 11,601,500 10,097,185 9,082,073 7,682,630 Net Income before tax 1,250,000 5,723,500 9,747,815 13,491,615 11,461,593 Income Tax @ 20% 250,000 1,144,700 1,949,563 2,698,323 2,292,319 Income after tax 1,250,000 5,473,500 8,603,115 11,542,052 8,763,270 (2,292,319) Add: Depreciation 10,000,000 7,500,000 5,625,000 4,218,750 3,164,063 Cash flow from Operations - 11,250,000 12,973,500 14,228,115 15,760,802 11,927,333 (2,292,319) Cash Flow Statement 2009 2010 2011 2012 2013 2014 2015 Consultancy fees upfront (12,000,000) (800,000) Cost of land (3,000,000) Land Development (5,000,000) (5,000,000) Machinery (16,000,000) (12,000,000) (12,000,000) 1,000,000 Working capital 1,500,000 1,732,500 1,984,500 2,257,369 1,914,422 Cash flow from Operations 11,250,000 12,973,500 14,228,115 15,760,802 11,927,333 (2,292,319) Net Cash Flow (36,000,000) (5,050,000) 2,706,000 16,212,615 18,018,171 13,841,755 (1,292,319) Cost of capital 15% Net Present Value (NPV) (9,617,462) Internal Rate of Return (IRR) 5% Read More